Question

Dewina Food Industries is considering the development of a new ketchup product. The ketchup will be sold in a variety of different colours and will be marketed to young children. In evaluating the proposed project, the company has collected the following information:

• The company estimates that the project will last for four years.
• The company will need to purchase new machinery that has an up-front cost of $30 million. At the end of the project, the company expect to sell off the machinery for $5 million.
• The machinery will be depreciated on a 4-year straight-line basis towards zero salvage value.
• Production on the new ketchup product will take place in a recently vacated facility that the company owns.
• The project will require a $6 million increase in inventory. The company expects that its accounts payable will rise by $1 million. After t = 0, there will be no changes in net operating working capital, until t = 4 when the project is completed, and the net operating working capital is completely recovered.
• The company estimates that sales of the new ketchup will be $20 million each of the next four years.
• The operating costs, excluding depreciation, are expected to be $10 million each year.
• The company’s tax rate is 28 percent.
• The project’s WACC is 10 percent.

Draw up the project analysis worksheet providing details of each of the three basic elements that must be considered in your evaluation and make recommendation based on the NPV and IRR criteria?  

Answer 1

Depreciation Per Year = (Value of Assets - Salvage Value) / Year in Use

Depreciation Per Year = (30 million - 0) / 4 years = 7.50 million

After Tax Salvage Value of Equipment = Salvage Value – Tax (Salvage Value – Book Value)

After Tax Salvage Value of Equipment = 5 Million - 0.28 (5 Million - 0) = 3.6 Million

Change in Working Capital = Change in Inventory - Change in Accounts Payable

Change in Working Capital = 6 million - 1 million = 5 million

Project is NPV Positive with NPV of $353,664.37

		0	1	2	3	4
1	Revenue		20000000	20000000	20000000	20000000
2	Operating Cost		10000000	10000000	10000000	10000000
3	Depreciation		7500000	7500000	7500000	7500000
4	Income Before Tax (1-2-3)		2500000	2500000	2500000	2500000
5	Tax @ 28%		700000	700000	700000	700000
6	Income After Tax (4-5)		1800000	1800000	1800000	1800000
7	Cash From Operations (6+3)		9300000	9300000	9300000	9300000
8	Cost of Machine	-30000000
9	Salvage Value					3600000
10	Change in Working Capital	-5000000				5000000
11	Total Cash Flow	-35000000	9300000	9300000	9300000	17900000
12	PV @ WACC 10% Discounting	-35000000	8454545.45	7685950.41	6987227.65	12225940.85
13	NPV - Sum of PV	353664.37

IRR is point where project Inflows are equals to outflows.

9300000/(1+r)^1 + 9300000/(1+r)^2 + 9300000/(1+r)^3 + 17900000/(1+r)^4 - 35000000 = 0

Solving the equation we get r = 0.1042 or 10.42%

Payback period -

Total Cash inflows in three year - 9300000 + 9300000 + 9300000 = 27900000 and remaining

7100000 form 17900000 cash flows in 4th year = 7100000 / 17900000 = 0.40

So 3.40 is total payback period.

To Conclude -

Project is NPV positive and IRR is greater than WACC of 10% so project should be accepted by the company.